2016 Capitalization Rate Expectations

As an extension of the CCIM Outlook Conference presented by the Miami-Dade/Monroe District of the Florida Chapter of the CCIM Institute, Blazejack and Company undertook an unscientific survey of attendees regarding their expectations regarding real property capitalization rates in 2016. Simply stated, the capitalization rate in a transaction is the percentage indicated when the net operating income is divided by the sale price. For instance, if a property that was producing net income of $7,000 per year sold for $100,000, the indicated capitalization rate would be 7.0%.

Our survey was simple:

What do you think will happen with real property capitalization rates in South Florida in 2016?

The PwC/Korpacz Survey has been undertaken quarterly for more than a decade and it is a recognized “ball parking” source for capitalization rate indications – particularly for rates applicable to institutional grade product. The survey provides valuable data on a host of topics, including yield and growth rates as well as retention percentages and TI expectations. Some of the capitalization rate data from their most recent survey follows:

Here is how one capitalization rate indication has changed in the response to the great recession and the recovery that has followed. This is the South Florida Office capitalization rate indication.

Of course, different participants in the real estate market regard capitalization rates from different perspectives. Investors (and lenders) who depend on leverage tend to be more concerned with mortgage interest rates. Here is a simplified mortgage/equity calculation using an interest rate of 4.5% and assuming a loan to value ratio of 65% and a 30 year amortization schedule. The indicated mortgage constant is 6.080%. In this instance we plugged in an equity return of 9%.

Lenders can use the same assumptions (without the need to make assumptions about the equity position) to determine what minimum capitalization rate will ensure the debt service coverage they seek. Since the great recession traditional lenders have been more focused on credit and cash flow than they have been on collateral. They simply multiply the coverage they seek by the loan to value ratio and they multiply the result by the indicated mortgage constant. Here is the “Bankers Cap Rate” calculation:

After holding interest rates at historic lows, the Federal Reserve finally acted to move interest rates up 25 basis points and indicated that further upward movement was to be expected. However, falling oil prices and a global economic slow down seem to be nixing that intent.
Cap rates are great, but in the digital age many more investors (and virtually all institutional investors) are more focused on IRR (internal rate of return) or the yield rate. Yield rates are more explicit than cap rates. Capitalization rates are applied to a single year stabilized net income estimate. Yield rates are used to discount the full slate of income cash flows anticipated from ownership, including the property sale at some future date. Yield rates are suitable for direct comparison to returns anticipated from alternate investment options. Since the pWc Korpacz survey also provides indications of yields sought by investors, we can use the data to examine the spread between yield and cap rates. This provides some indication as to whether there is “cushion” to absorb interest rate increases without a cap rate increase. Here is a graph showing the historic relationship between yield rates (IRR) and cap rates.

Since the 1Q2008 survey, the average spread between the average quoted Yield Rate and the average quoted Capitalization Rate has been 1.35%. It has fluctuated between .67% and 2.70%. As of the end of 2015, the spread was 1.15%. So, while there is some cushion for cap rate movement, there is not a lot.

Thanks again for participating in our study. We hope to be able to work with you on your most interesting real estate problems in the coming year.